Financial reporting is one of the most important accounting practices that profit and non-profit making organizations should integrate into their operation. Public organizations are under a legal obligation to disclose their performance to the public. One of the ways through which they attain this is by publishing their financial statements. Different stakeholders use financial reports for different purposes. Some of these include shareholders, creditors, potential investors, customers, and governments. Therefore, the effectiveness with which organizations undertake their financial reporting determines the value of the information reported to these stakeholders.
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The high rate at which globalization is occurring coupled with the economic integration that is being undertaken has increased the need for international convergence about financial reporting (Delaney &Whittington, 2011, p.142). To improve their accounting quality, most countries across the world have adopted International Financial Reporting Standards. For example, most publicly accountable organizations in Canada have replaced the Canadian Generally Accepted Accounting Principles (GAAP) with IFRS (Greuning & Koen, 2001, p.34).
Despite this, the choice of accounting system adopted by organizations can have significant effects on their financial reporting. There are two main accounting methods that an organization can adopt in preparing its financial reports. These include historical cost and fair value accounting. Historical cost refers to the price that was paid to acquire a particular asset. On the other hand, the current cost accounting involves a method of reporting revenues, liabilities, and assets at their fair value/ current cost or the price that the organization would realize if it sold its assets (Delaney &Whittington, 2011, p.142). Alternatively, current cost or fair value also refers to the price that an organization would pay to relieve a liability.
Over the years, there has been increased debate amongst practitioners and academicians on the most appropriate accounting method to adopt. This has arisen from an increment in the degree of complexity about the use of financial instruments and the need to manage risks (Luis, n.d, p.343). For example, some individuals argue that historical cost may be rendered obsolete while others argue that historical cost should be modified or be replaced with the current cost accounting system. In the past few decades, there has been an increased preference for the current value method of accounting by organizations over the historical cost accounting method.
However, it is important to note that the outcome of the current value method of accounting is depending on the market forces. Additionally, the decision between the two methods involves a cost-benefit tradeoff (Delaney &Whittington, 2011, p.142). This paper entails an analysis of the current value and historical cost accounting methods to determine which of the two methods provides a more useful measure of income for users of financial reports.
Analysis of current value and historical cost accounting methods
To evaluate the appropriateness of current value and historical cost accounting methods, this paper has taken into account several aspects.
Relevance in making investment decisions
Current value accounting is a more effective measure of income due to the degree of relevance associated with the financial reports (Deng, 2005, p.32). Current value accounting indicates how transactions are conducted in the real economic world. Additionally, current value accounting is based on the market value which better indicates the economic reality of a particular transaction. The resultant effect is that it provides more relevant and useful information. For example, consider two organizations A and B.
If the debt-equity of organization A is comprised of a loan of $1 million, 10 years to maturity at a 3 percent interest rate while that of B is comprised of a similar loan amount and date to maturity but at an interest rate of 8 percent, the financial position of the two companies are similarly based on historical cost. However, based on the interest rate, the assets of organization B are more valuable compared to that of A. By reviewing the financial position of the two companies, it would be difficult for an investor to tell which of the two is most valuable. Therefore, historical cost accounting is not more useful in making investment decisions.
Additionally, financial information obtained from financial reports prepared using historical accounting can be misleading. This arises from the fact that historical cost accounting is based on inconsistent principles. By using historical figures, creditors and investors may be misguided in making decisions related to the extension of credit finance and investing their money (Delaney &Whittington, 2011, p.147). This is because the accountants will only present historic costs rather than provide the actual and current valuation of the organization. Therefore, one can assert that it is possible to commit injustice and dishonesty to investors and shareholders using historical cost accounting than when current cost accounting is adopted.
Financial statements provided using the fair value accounting method are more realistic and accurate compared to those provided using the historical cost method. This is because the various components of the financial reports are presented in their actual value.
Additionally, when using the fair value accounting method, organizations are required to provide full disclosure of the changes in their financial information. This is achieved through the provision of footnotes. As a result, users of financial reports become more informed regarding the operation of a particular organization (Delaney &Whittington, 2011, p.142).
In their decision-making process, users of financial reports are more concerned with the current value of the assets and liabilities. The current value accounting method takes into account the fair value at which transactions occur. This makes the users of financial reports effective in their decision-making. For example, in their operation, financial institutions cannot extend credit facilities to organizations based on the historical cost of the collateral used (Lussier, 2012).
Therefore, fair value accounting provides investors with a clue on the actual health of the organization in which they intend to invest. Proponents of current value accounting assert that fair value accounting can be very valuable to banks. This is because it provides financial report users with timely information regarding the health of the financial institutions compared to historical cost method. This means that the information provided through current value accounting can be relied upon by bank regulators such as governments to implement regulations meant to avert occurrence of financial trouble such as the previous financial crisis (Muller, 2008, p.65).
Currently, the market has become very dynamic and volatile. As a result, it has become paramount for financial reports to illustrate the prevailing economic environment rather than providing a summary of historical transactions. For example, the prices of assets such as stocks change from time to time. In making their investment decisions, potential investors are mainly concerned with the fair value of such assets. This is due to the fact that the fair value indicates whether the investor will get higher returns or not.
This makes current value accounting to be more appropriate in making investment decisions for example on whether to purchase financial securities of a particular institution compared to historical cost accounting. Despite the fact that current fair value account can be characterized by a certain degree of subjectivity, it provides more relevant information (Deng, 2005, p. 35). Historical accounting method was designed to be used in situations where prices are relatively stable or change slowly.
One of the conventional theories of management asserts that managers should act as stewards of the shareholders and creditors. This means that they are supposed to ensure that the funds entrusted to them are well utilized. In this situation, financial accountants will mainly focus on historical cost so as to meet the creditors and owners primary concern. Historical cost is a more appropriate method of accounting to shareholders. This arises from the fact that the financial reports are based on the historical cost which means that equity holders can able to determine the effectiveness of the managers.
For example, by analyzing records of past transactions, equity holders can be able to determine the level of accountability amongst the managers. Additionally, income is an appropriate measure that can be used in the process of determining the management’s performance. Therefore, one can conclude that historical cost accounting is very effective in executing the control duty of financial accountants. In this case, the net-worth of the organization is not an important measure.
The measure of economic reality, market efficiency, and firm valuation
The debate regarding the appropriateness of historical cost accounting and current value accounting is based on the difference between reliability and relevance. Because current value accounting is based on the current market values, it is more effective in indicating estimations and expectations of an organization’s assets’ value, future cash flows, riskiness, and timing attributable to assets compared to historical cost accounting which is more outdated. Historical costs cannot also be compared across organizations. This arises from the fact that the transactions were entered under different environments and dates. This means that historical cost does not form the basis of making useful decisions (Khurana, 2003, p. 19).
Additionally, because market efficiency is based on expectations about transactions, current value accounting is more appropriate in measuring the degree of efficiency in the operation of an organization (Mard, Hitchner & Hyden, 2010, p. 18).
Financial reporting using the current costing method requires organizations to separate their profits/earnings into parts that show which part emanated from holding assets before their sale. By separating the profits, users of financial reports can be able to determine the degree of efficiency with which an organization implements asset management decisions. Failure to recognize the different parts of an organization’s earnings may lead to unintended capital erosion. Additionally, reporting of holding gains separately can enable users of financial reports to conduct a correct assessment of the organizational managers’ operational performance (Mard, Hitchner & Hyden, 2010, p. 19).
Even though historical cost indicates the historical market value of a particular transaction, the values provided are not representative of the current value of liabilities and assets. The historical cost approach does not provide the relationship between an organization’s performance and its market capitalization. As a result, historical cost accounting limits financial analysts’ and shareholders’ ability to evaluate the financial performance of organizations because the historical costs do not take into account changes in market conditions (Greening & Koen, p.47). The historical cost accounting method does not take into account future values. This means that it cannot give investors a clue on the future performance of their investment.
Additionally, historical costs are not comparable between firms. This is because transactions between firms may have been entered on different dates and prices. Therefore, historical cost is not much use in making decisions. As a result, current fair value is more useful to investors because historical cost usually lacks comparability and is outdated.
Reliability and relevance
Decision on the accounting method to adopt when preparing financial reports is dependent on the divergence between reliability and relevance. Current value measurements are more relevant and reliable compared to historical cost measures which do not have any relationship with the current values and as a result lack any form of comparability amongst firms. Additionally, fair values effectively reflect the economic reality within which financial transactions occur. As a result of their relevance and reliability, fair value measures are very useful in making decisions compared to historical costs (Deng, 2005, p. 36).
Because fair value accounting takes into consideration the market price of assets and liabilities, it is a more effective method of basing expectations compared to historical cost accounting methods. Despite this, some proponents argue that the historical cost method is more effective in that it is characterized by a relatively low margin of error and minimal bias. However, the reliability of current value measurement depends on the quality of the financial information, that is, the degree of verifiability, neutrality, and representational faithfulness. Additionally, estimating the current value of assets and liabilities is more effective if trading of financial instruments occurs in a liquid market (Allen, 2008, p. 359).
However, in the event of low liquidity within the market, it is not possible to estimate the current value of assets and liabilities.
This means that estimation becomes subject to managerial judgment whereby uncertain assumptions are made. This further means that the reliability of the current value in such a situation is reduced significantly. According to Allen (2008, p. 359), the higher degree of subjectivity involved in the process of estimating the fair value of assets and liabilities, the higher the reliability concerns. Therefore, proponents of historical cost accounting assert that personal judgment plays a role in the determination of current value rather than the market forces which increases the degree of subjectivity.
In undertaking their financial reporting duty, accountants are mainly concerned with ensuring transparency and improving the reliability of financial information and estimates to enhance the decision usefulness of the financial reports. Using current or fair value accounting increases the degree of reliability of the financial reports. This arises from the fact that a higher degree of transparency and information quality is attained.
Performance reporting and smoothing
In their operation, financial managers must ensure that the financial reports such as the income statements and balance sheets provided to various users are free from any form of manipulation to enhance the credibility of the financial information provided (Tucker & Zarowin, 2006, p. 270).One of the ways through which managers influence financial reports is by undertaking income smoothing. Income smoothing refers to attempts by managers to intentionally reduce the fluctuation of their organization’s earnings.
Because the historical cost accounting method is based on the actual price of the asset or liability, organizations’ management teams can influence reported income. For example, if a firms’ earnings during a particular financial period do not meet the benchmark, managers can manipulate the earnings in historical cost accounting.
However, income smoothing is significantly reduced under current value accounting. This arises from the fact that the price of the assets in the financial statements is already reflected in their fair value. Recording of assets and liabilities under the current value accounting method is undertaken continuingly. Therefore, if an organization adopts the current value accounting method, it has to ensure that it indicates the changes in the fair value of its assets and liabilities. This is attained by incorporating the concept of depreciation which is an indicator of changes in market conditions. This means that the price of the assets and liabilities on the balance sheet reflects the prevailing market value on the balance sheet date (Michaelson, Wagner & Wooton, 2000, p. 143).
One limitation of current value accounting is that it is characterized by a high degree of volatility. This arises from the fact that the price of assets adjusts by the market changes. For example, if the current value of an organization’s long term debt decreases as a result of a downgrade in its credit rating, the organization will record again rather than a loss in its financial report due to lower valuation in its long-term debt (Griffin, 2012, p.56). If this occurs in an organization that has adopted current value accounting, it will report the effect of these changes in its financial report which is a more realistic outcome.
Therefore, using current value accounting significantly reduces the probability of an organization undertaking income smoothing. Additionally, if an organization’s degree of exposure to market risk increases, organizations which have adopted fair value accounting can be able to identify such risk and respond appropriately. This means that users of financial reports can make their decisions more effectively.
From the above analysis, the differences between historical cost and current value accounting methods have been evaluated. For example, financial reports prepared on the basis of historical cost rely on the price of past transactions while those prepared using current value are based on the prevailing market price. Additionally, it is also evident that that the usefulness of financial reports prepared using current value and historical cost accounting methods differs across different users with regard to the appropriateness of the financial information provided as a measure of income.
Financial reports prepared using current value accounting are considered to be more effective in the process of making investment decision compared to those prepared using historical cost. This is due to the fact that current value effectively reflects the prevailing market conditions. Additionally, current value accounting requires financial reports to be supplemented by footnotes which explain the figures provided in the financial reports. As a result, users of the financial statements gain a better understanding of the reports. This means that on the basis of the information provided using current value, investors can be able to make more optimal decisions.
On the other hand, basing investment decision on the information provided by financial reports prepared on the basis of historical cost may result into loss for their users such as the investors. This arises from the fact that historical cost accounting assumes that the markets are stable or change slowly. However, markets are very dynamic which means that the financial reports will not reflect the changes in market conditions. Additionally, the financial reports prepared using current value accounting method are more realistic and accurate compared to those prepared using historical cost. For example, financial reporting using current value provides stakeholders such as potential investors with the actual financial health of the institution. As a result, it is possible to make optimal investment decision.
Despite its limitation with regard to providing financial reports on the basis of historical prices, historical cost accounting is a very effective measure of income especially to shareholders and creditors. This arises from the fact that it enables these stakeholders to evaluate the effectiveness with which the managers are utilizing their funds.
The appropriateness of current value accounting is also increased by the fact that it is effective in reflecting market efficiency. This means that the information provided by financial reports prepared using current value accounting can be used by different stakeholders to forecast how the organization’s future performance will be like. For example, potential investors can project the firm’s future cash flows. However, this is not possible in historical cost accounting because the prices used tend to be outdated. Additionally, it is also not possible to conduct a valuation of a particular organization on the basis of historical cost.
Current value accounting ensures that the financial reports portray the prevailing economic reality. For example, in reporting the profit earned, organizations are required to illustrate the various parts that compose the profit. As a result, the users of financial reports are able to gain knowledge regarding the effectiveness with which a particular firm manages its assets.
Historical cost accounting provides managers with an opportunity to undertake income smoothing. Through income smoothing, managers can have adjust the performance of an organization in the financial report. The resultant effect is that the users of financial reports will not be able to assess the actual financial health of the organization. This also means that it is possible to mislead the users of the financial reports for example in the event that the earnings did not turn out as expected. This means that the financial information provided can be misleading. However, in fair value accounting, it is not possible to undertake income smoothing.
As a result, increases in the degree of reliability of the information provided in fair value accounting increases the degree of transparency associated with this method. Current value measures are more reliable and relevant in the process of making investment decisions. As a result, most investors rely on current value measures in making their investment decision. This underscores the fact that current value is a more appropriate measure of income for users of financial reports compared to historical cost.
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